Commentators sing
it from the same hymn sheet: Shareholder activism is on the rise, and
more is expected to come, particularly from institutional investors
(hedge funds, union funds, and pension funds), who have more muscle,
interest, and expertise to challenge executives and the board. The
effectiveness of traditional defense mechanisms such as poison pills,
dual-class shares, and staggered boards is decreasing and regulatory
forces keep shifting the balance of power toward shareholders—at the
expense of the directors.

While how the battle is fought largely
depends on the dynamics between activists and the board,
boards—especially in continental Europe—still seem to overlook,
downplay, or simply ignore shareholder activism. Throughout my academic
work and in my role as practitioner, I've had conversations with
numerous board members, executives, corporate secretaries, investor
relations professionals, proxy advisory representatives, and the
activist community. The message is clear: The approach that directors
adopt toward shareholder activism is not strategic, not proactive, and
based on hastily made ad hoc decisions. Companies consider themselves
safe from activists' attacks when, in fact, they are not. What they
overlook is that neither a large blockholder nor good financial or
social performance shields them from becoming a target. And companies
often misjudge the perils of peripheral players who, while small in
terms of shareholdings or assets under management, are exceptionally
well networked, knowledgeable, and highly motivated to realize their
goals sometimes up to the point of personal sacrifice and foregone
financial wealth.

This may lead to high financial and reputational
losses from which companies recover only slowly, if at all. Indeed, an
interview-based study by McKinsey & Company1
estimates that each contested campaign costs a company between $10
million and $20 million. A related recent survey of activist
shareholders by Schulte, Roth, & Zabel2
unveils that activists view active dialogue as their most effective
strategy and, at the same time, as the most effective defense mechanism
that directors can use when it comes to preventing contentious public
attacks. Clearly, directors need a more strategic, more preventative,
and more engaging approach. In other words, they need to implement
strategic shareholder management.

Strategic shareholder management
refers to all actions taken to analyze activist shareholders and their
identities, plan for appropriate answers to their likely questions, and
implement procedures aimed at achieving long-term cooperation and
interest alignment with activist shareholders. Strategic shareholder
management is a tailored approach, tailored to the needs of each
individual organization and its unique situation. As a result,
ready-made instructions are difficult to provide. Nonetheless, the
following elaborations contain a high-level and hopefully helpful road
map for implementing a strategic approach to engaging with shareholder
activism.

Inside-Out Analysis

The
first step in adopting a strategic approach to shareholder management
consists of gaining an understanding of one's identity. An answer to the
question of “who are we as an organization” almost always entails an
answer to the question of what we deem as rightful and appropriate
behavior and what we consider to be outside the realm of legitimate
actions. In other words, it entails a statement of the company's own
motives and objectives. However, most importantly, seeking to understand
one's identity inevitably involves considering whose interests the
company exists to pursue.

Companies may adopt a stakeholder or a
shareholder approach and may thus make decisions so as to prioritize the
interests of all stakeholders or only those of shareholders. Boards can
go further, for example, as suggested by the Policy Governance
approach, distinguishing between the interests of different groups of
legal owners (shareholders), moral owners, and remaining stakeholders.
In any case, finding one's place in the stakeholder versus shareholder
space is important because it provides a rough guideline on how to
engage with shareholder activists—social and financial alike.

Managing
one's interface with shareholders almost always means having an
appropriate answer ready for an activist's question. While companies may
choose to lean more toward one or the other end of the continuum,
adopting a stakeholder versus a shareholder orientation is not mutually
exclusive. In fact, companies may choose to place equal emphasis on both
orientations and adopt a shared-value approach (see Figure 1).
The Swiss-based Nestlé is a case in point. Nestlé prides itself on
creating shared value for all its stakeholders, including shareholders,
equally. Such an approach has a plethora of implications, ranging from
the design of incentive systems (who and what to reward) to financial
reporting (how frequently to report). As a result of their shared-value
approach, Nestlé, for example, renounced quarterly earnings statements
and chose to publish its earning statements biannually. Whatever the
orientation and objectives, companies are well advised to find their
place in the stakeholder-shareholder matrix and formulate ways to
convincingly defend it.

Figure 1. Inside-Out Analysis

Activist Analysis

Once
the company has gained clarity over who it is as an organization, the
next step consists of analyzing its shareholders and potential
activists. Before potential activists can be identified, any
organization is well advised to identify its current shareholders. Such
engagement provides them with useful insight on who their key
shareholders are and what these shareholders' exit versus voice strategy
might be. In fact, a study of 50 large European and US companies found
that a maximum of only 100 current and potential investors significantly
influence the share price of most large companies.3
Identifying these critical shareholders and understanding what
motivates them may help in making accurate predictions of their behavior
and, consequently, the direction of the stock price.

Shareholder
identification builds a sound basis for identifying potential activists
among one's current and prospective investors. To understand how
shareholder activists make their targeting decisions about which
companies they should seek to influence, my colleagues and I
investigated the mission statements of 120 US institutional investors
who used the proxy process in 2009 and 2010 and filed a resolution
against their organizations.4
Our qualitative analysis of these mission statements yielded seven
distinct types of activists that can be arranged on a continuum
depending on whether they pursue single, unidimensional objectives
(i.e., financial performance) or complex multidimensional objectives
(i.e., social performance or education/raising awareness objectives on
top of financial objectives). We then performed a series of regression
analyses to predict the targeting choice of each type of activist. As Figure 2
demonstrates, shareholder activists' objectives vary systematically
with their identities—the definition of who they are as activists—as
described in their mission statements.

Figure 2. Activist Analysis

We
find that, in general, activists' objectives differ in scope: The first
three types of activists on the left-hand side of the continuum
emphasized service to their clients as their primary raison d'être as
activists. The last three types of activists on the right-hand side of
the continuum view their mission as activists more broadly to serve
special stakeholder groups (e.g., employees) or the society at large
with socially responsible investors being somewhere in the middle.
Because identities shape objectives and define success, they also shape
targeting decisions. As a result, when engaging in activism,
shareholders on the left-hand side of the continuum typically pursue
changes in single firms; those on the right-hand side of the continuum,
by contrast, often single out those firms most likely to change the
entire industry or market. As the Teachers Insurance and Annuity
Association–College Retirement Equities Fund (TIAA-CREF) CEO once put
it: “The significance is not the three or four laggards you catch—it's
that you get the herd to run. We need to scare all the animals.” It
follows that hardly any company is safe from activists' attacks. Even
well-performing companies that score high in terms of both social and
financial performance can become targets of activist shareholders if
they are large and visible so as to attract a lot of attention. In
analyzing activists, companies can use our typology to map their current
and prospective investors and assess these activists' targeting
decisions.

Vulnerability Assessment

Once
key shareholders are identified, the next step consists of estimating
one's likelihood of becoming a target. A vulnerability assessment refers
to the process of identification and weighting of factors that make a
company susceptible to activists' attacks. Vulnerability assessments are
becoming more popular in recent times. As a BusinessDay online
article informed earlier this year, investment banks have started
offering vulnerability assessment to their clients and advising them on
how to anticipate and thwart vocal investors. It is reported that
Deutsche Bank offers what it calls a “vulnerability assessment,” while
Barclays has developed a “proprietary model” that identifies companies
most at risk from activism. Other banks including Goldman Sachs, Morgan
Stanley, and JPMorgan Chase have followed suit and pitch similar
services to head off activists.5 Vulnerability assessments are becoming an essential tool in dealing with activism.

Because
vulnerability assessments will vary from company to company due to the
companies' unique shareholder and activist makeup, it is rather
difficult to provide an off-the-shelf, ready-to-use template. That said,
the set of factors that should enter the vulnerability assessment are
more or less finite. They refer to those issues that might catch an
activist's eye given their investment strategy and targeting objectives.
As hinted above, shareholders' investment strategy and their targeting
decisions are related: Financial activists (i.e., those on the left-hand
side of the Figure 2
continuum) engage in activism in order to realize their investment
objectives. Social activists (i.e., those on the right-hand side of the Figure 2
continuum), by contrast, (also) invest in order to realize their
targeting objectives. In extreme cases, social activists buy stock just
for the purpose of activism. In other words, in these extreme instances
investments are means to ends and activists use their ownership rights
to push through their personal, educational, and/or political interests.
Admittedly, these extreme cases are rare, but they exist.

Most
commentators and advisors on shareholder activism focus on financial
activists and those issues that make companies vulnerable to financial
activists' attacks. In their Harvard Business Review article, Coyne and Witter6
categorize investors into financial addicts, strategy junkies, and
organizational mavens. Financial addicts, on the one hand, engage in
what can be termed balance-sheet or financial activism.
The set of factors that makes companies vulnerable to these activists'
attacks are related to the company's financial condition, core assets,
and results. Consequently, to assess their company's vulnerability to
become a target of balance-sheet activism, directors should scrutinize
things like earnings estimates, operating margins, and capital
deployment decisions, including stock repurchases and dividends.

Strategy junkies, on the other hand, engage in a type of activism that is commonly referred to as income-statement or operational activism.
Income-statement activists focus on issues that affect a company's
income statement or cash flow. They are particularly wary of the
company's cost structure, technology, and products and services.
Targeting is triggered when companies accumulate high cash flow
reserves; when they have an unfavorable cost structure, high research
and development (R&D) expenses, high restructuring costs, or when
they are on the verge of losing market share or competitive advantage to
their competitors. A vulnerability assessment evaluating the
possibility of becoming a target of income-statement activism thus
includes investigating whether the company can be accused of hoarding
cash or to have a bad business strategy or poor operational execution.

Organizational
mavens, finally, investigate a company's leadership structure and
governance. Organizational mavens engage in what some have termed governance activism.
Governance activists target companies that they believe have a poor
executive team, CEO, or board. They also become active when dissatisfied
with the design of executive compensation or when they don't see the
link between executive pay and company performance. Poor governance in
general, such as the appointment of directors that they believe lack
sufficient independence, or the implementation of takeover defense
mechanisms (such as dual-class shares or poison pills) are also among
the factors that make a company vulnerable to governance activists
attacks. In assessing their vulnerability, companies should examine to
what extent they abide by principles (and codices) of good governance,
and if they don't what kind of explanation they can reasonably provide
for their noncompliance.

Often neglected, yet no less important,
is social activism. Because social activists often hold only few shares,
companies tend to underestimate their impact. However, when their cause
finds the ear of a broader audience, they can become a source of almost
irreparable losses to company and director reputation. A prominent case
in point is Daniel Vasella, the former CEO and chairman of Novartis,
the Swiss-based pharmaceutical company, who was accused of receiving a
fat-cat salary and surrendered to public pressure, renouncing his
“noncompete” pay-out of $78 million.

Social activists thus are
well-informed, well-networked, and very persistent and can become very
powerful. As a result, companies are well advised to include social,
environmental, and spiritual factors into their vulnerability
assessment. A good way to do this is to include their social rating
scores into their analysis. A number of organizations, such as Risk
Metrics, provide such scores. Companies can then use the movements in
these scores as an early warning system and brace themselves with
answers should activists come knocking on their doors.

A final
step necessary in the vulnerability assessment is the weighting of
factors that found their way to the list. Be it due to a different
shareholder makeup, company size or visibility, or different industry or
sector, the factors discussed above will not be equally important for
all companies. Instead, directors should additionally assess each factor
according to the impact it has commensurate with its potential to hurt
the company's financial and reputations capital. The factors can then be
mapped in a vulnerability scorecard (see Figure 3),
providing a quick insight into the vulnerability level at a given point
in time. Needless to say, the vulnerability assessment should be
periodically repeated. Again, movements of factors in the scorecard
provide a convenient early-warning system.

Figure 3. Vulnerability Scorecard

Action Plan

Within
the realm of strategic shareholder management, the inside-out analysis,
the analysis of activists and the vulnerability assessment are,
essentially, pieces of an integrated action plan. A strategic approach
to shareholder management requires the establishment of a working group,
a flexibly composed team that counts the CEO and one or two
nonexecutive directors (e.g., the chairman of the audit and the
governance committees) among its members. C-suite and board-level
representation assures that the topic obtains the attention that it
deserves and signals to internal stakeholders the commitment by the
highest organizational ranks. It also assures that enough financial and
other resources will be devoted and that the right processes will be put
into place. These include a clear assignment of duties and
responsibilities and a sleek information flow inside and outside the
organization (see Figure 4).

Figure 4. Action Plan

Among
the team members, in large organizations, are cross-functional internal
and external experts, including corporate secretaries, legal counsels,
investor and public relations officers, and compensation and corporate
governance consultants who are assigned the tasks of identifying
shareholders, performing shareholder and activist analyses, and
conducting vulnerability assessments. The team should also be staffed
with communications specialists who take care of informing and engaging
internal and external stakeholders and nurturing the relationship with
the investors' and activists' community, proxy advisory services,
analysis, regulators, and the press. The team should also design a task
force entrusted with the evaluation of any issues or decisions taken
that could increase the company's vulnerability. This task force may use
a number of means to assess and predict activists' reactions. They may,
for example use the five-hats riddle whereby members of the team put
themselves in the shoes of different types of activists and comment on
an identified issue or a future decision to be announced. In any case,
what is important is that the insights of all analysis are synthesized
and utilized for formulating the right message, to the right audience in
a language that shareholders understand. In any case, each procedure
should aim to equip the company for the establishment of a constructive
relationship and interest alignment with its current and prospective
shareholders. This is, in a nutshell, the key objective of strategic
shareholder management.

Prior to joining Korn Ferry, Dr.
Katarina Sikavica, spent ten years in academia where she specialized in
corporate governance, and particularly organizational ownership and
shareholder activism. She holds a PhD from the University of St. Gallen,
Switzerland, and an MA from the University of Zurich, Switzerland. For
more information, seehttp://katesikavica.com/.